As Earnings Loom, Call-Option Selling Blooms

With option prices soaring, traders look for some easy money.
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Earnings week can be an expensive time to buy options, but sometimes it is just the perfect time to sell them.

In the days leading up to a company's earnings report, options can become very pricey because speculation increases and drives up prices. Market-makers on the trading floor know at such times they're essentially selling beer on Super Bowl Sunday, and buyers won't be put off by high prices.

But there's a way to play the markup in options ahead of earnings, especially if you're a long-term shareholder in, say,

IBM

(IBM) - Get Report

without paying top-shelf prices.

Covered call writing, the strategy of selling call options against a stock position, may be a worthwhile consideration during earnings seasons, especially in options due to expire at the end of the week.

On Wednesday, for example, IBM is set to report

after the close, and the stock has been hovering at 115 3/16, down 9/16.

IBM's January 115 calls were trading for about 4 ($400 per contract) and had posted volume of more than 900 contracts by midday. "If you've owned IBM since it was trading at 20 and had multiple splits, you're not going to sell it now," said Paul Foster, the options strategist at

1010WallStreet.com

. "Why now sell some calls at these prices?" January 120 calls, by the way, were selling for 2 ($200) and have been among the most actively traded Wednesday with volume of more than 2,000 contracts.

With just two days before those options expire, betting on a 5-point move seems a bit chancy to Foster. "Why would you buy options with just three to four days left before expiration? That's not trading, that's gambling," he said. "If you see some call options that are expensive, why not sell some and take in some premium?"

While call-buying is seen as a bullish signal, selling those options is a more neutral or bearish strategy that allows an investor to get paid for selling the option on the chance that it will expire worthless. The seller's obligation, however, is to deliver shares at the strike price when those contracts are exercised. It means you can be forced to sell a stock for 70 even if it's trading at 75.

Selling, or "writing," covered calls can help pad returns, particularly if the investor is going to hold on to the purchased stock. (All covered calls mean is that you are "covered" by owning the underlying stock.)

Essentially, selling IBM's January 120 calls is an investment that pays off if IBM's earnings fail to propel the stock to those levels by Friday's close, leaving the option to expire worthless. If IBM shares hit, say, 123, the buyer can exercise and the seller loses his IBM shares for 120, plus the 2 he's taken in for the options.

To protect themselves in such situations, options market-makers who are frequent sellers during expiration week to fulfill bullish demand, figure in a greater volatility number that increases the price of the option. Volatility is an annualized measure of how much professionals think an underlying stock can move with higher volatility denoting greater uncertainty about a stock.

This week, for instance, IBM's at-the-money call volatility measure is 96, a sky-high level compared to the usual 30-to-40 range, but not unusual because earnings speculation has moved way up among favorite American pastimes.

"That's a huge number because speculation is huge. And if the stock doesn't move after earnings, or if it goes down, that volatility number is going to go down. The stock price goes down. The price of the calls evaporates," Foster pointed out, leaving the call-seller a winner.

Speaking of which, Microsoft reported earnings

Tuesday, and a look-a-here illustration at just how quickly call option values can vaporize after the news is out and uncertainty goes away.

On Tuesday, its January 115 calls were fetching 3 3/8 ($337.50) at midday trading. By Wednesday, the stock had shed 6 3/16 to 109 1/8, and those same calls were trading at 5/16 ($31.25).

Finally, though

Tyco's

(TYC)

stock was down 1 1/16 to 38 15/16, the February 35 calls were trading up 3/8 ($37.50) to 5 5/8 ($562.50) on volume of over 8,000 contracts.

And even some out-of-the-money calls -- those call options trading at a strike above the current stock price -- were up slightly; February 40 calls have gained a slight 3/16 ($18.75) to 2 11/16 ($268.75).